The disappearing index effect
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For decades, investors assumed that when a stock is added to an index – such as the S&P 500 – its price goes up and produces positive excess returns, while stocks deleted from an index typically yield negative returns.
However, this “index effect” has largely disappeared in the past decade, said Robin Greenwood, professor of finance and banking at Harvard Business School and State Street Associates academic partner. Nowadays, he explained, the average index addition or deletion experiences near-zero returns.
“In the 1990s, stocks that were added to the S&P 500 generated around 7 percent in returns. Today, added stocks produce roughly a half percent,” said Greenwood, noting that this declining pattern is also evident in index deletions.
Using the S&P 500 index for his analysis, Greenwood presented four explanations for the disappearing index effect.
According to Greenwood, the size of the added or dropped firm is linked to the magnitude of the index effect. Though companies typically benefit from greater investor attention and analyst coverage before an index change, larger firms may experience larger returns. Also, he argued, the size of the addition or deletion relative to the total capitalization of the S&P 500 has been shrinking over time.
Migrations/offsetting demand shocks
“More mid-cap stocks are moving into the S&P 500 from other indices,” said Greenwood, adding that migration returns tend to be significantly smaller.
“Stocks are coming to the index from another index rather than coming out of nowhere,” he said. “Migrations are still a larger share of additions than deletions today.”
However, in the 1990s, migrations made up the bulk of index additions and few-to-no deletions. Together they now make up over 70 percent of index changes, according to his research.
More predictable demand shocks
Index changes are becoming more predictable. Entire trading desks dedicated to monitoring and betting on index changes purchase additions and sell deletions long before a formal announcement.
“Sell-side desks put out short lists of potential changes,” causing the price of a stock to move days before an official change and, therefore, offsetting demand shocks, he said.
“Forecasting flows in the market is happening more and more these days,” Greenwood said. “Forecasting wasn’t really happening in the 1990s.”
Liquidity and better event arbitrage
There is more liquidity in the general market than in the past. According to Greenwood, the stock market has evolved, becoming better at providing liquidity to index additions and deletions.
“The market has gotten more efficient at accommodating these changes and flows,” he said. In particular, Greenwood points to passive investors who employ large teams of personnel and resources to study and improve liquidity around rebalancing the index.
Greenwood concluded that inclusion effects are the result of a number of changes taking place in the financial industry and markets. From better forecasting of flows to increased efforts at creating market liquidity, investors are focused on mitigating price impacts, and are likely contributing to the disappearing index effect.